Big changes in store for how feds calculate inflation

Starting in 2014, inflation at the wholesale level will be measured by the government in an entirely new way.

Fear not, though. American consumers and investors suddenly won’t be confronted with news that inflation is much higher than it’s been reported. The big do-ever in the producer price index is unlikely to make large alterations in the inflation outlook.

So why is a government agency notoriously prone to caution undertaking the switch? Simple. The old producer price index focused entirely on the price of goods even though the U.S. has become a service-dominated economy.

The new formula will incorporate price changes in services such as health care, financial advice, housekeeping, commuting, food delivery and the like. That’s the most important adaptation.

What’s more, the new PPI will take into account exports, the cost of government purchases and construction – an industry whose prior omission was always rather odd. The cost of producing a home is no small thing for a society with such a high level of home ownership.

Under the old method, investors and economists mostly focused on the increase in the overall producer price index and the so-called core PPI that strips out volatile food and energy costs. Food and energy prices can gyrate sharply in the short run, making it hard to figure out if the longer-term trend in inflation is up or down.

The new formula includes both those categories but under different guises. From now on the producer price index will be known as the “producer price index for final demand.”

That number will be further broken down into “final demand goods” and final demand services,” giving us a more precise idea of where inflation is rising (or falling) the fastest.

The core PPI, for its part, will now be called “final demand less food, energy and trade.” The government is also stripping out exports because they have little or no effect on domestic inflation.

So what kind of effect on PPI can be expected? Government economists reworked older reports under the new formula and some months show significant changes. Yet the annual growth in wholesale inflation remained little changed – it’s still quite low.